January – March 2007

April 24, 2007

As value investors, dealing with uncertainty, we run the risk of making errors of omission – where large gains are foregone because we were trying to minimize the probability of a bad decision. That risk is there in the relatively large cash and near-cash balances we carry. The portfolio performance should be considered satisfactory even after adjusting for the counter-intuitive “risks” of cash in the portfolio.

Human beliefs, which are programmed in our brains by our genes, make us prone to quick decisions (not necessarily wise ones), ignore numbers, seek representativeness and see patterns where there is only randomness. We are influenced by authority and social proof, prefer consistency and have a liking for magical thinking. Pattern recognition is the way human neural networks appear to operate. Pattern matching is the way humans perceive, remember and comprehend. Human thus love to generalize and draw analogies. The issue then is the degree to which our beliefs correspond with “reality”.

The human belief engine had its evolutionary roots in attempting to reduce uncertainty and make the world more predictable. Whilst human history has witnessed a systematic reduction in the perceived uncertainty with the physical environment (thanks to science and technology) and thus the sources of uncertainty to be explained by beliefs embodied in magic, the consequence has been a more complex human environment and thus an increase in uncertainties that arise from the human environment. The characteristics of human behavior that had their roots in human interactions in a setting of hunter/gatherer societies produced genetic predispositions that were violated in impersonal exchange. One such human artifact is the stock exchange – a precarious playground in which players with imperfect information deal daily with change and uncertainty.

Investors thus have to constantly probe their belief structure and seriously question beliefs that do not work – for that is the only proof that their mental models correspond with an ever changing “reality”.

Whilst we are measured and remunerated on the market value of the portfolio, we do not consider this to be sole barometer of performance. Benjamin Graham and David Dodd stated in Security Analysis: “…the bona fide investor does not lose money merely because the market price of his holdings declines, and the fact that a decline may occur does not mean that he is running a true risk of loss…we apply the concept of risk to a loss which is either realized through actual sale, or is caused by a significant deterioration in the company’s position – or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.” We apply the price v/s value test constantly to our holdings and to other opportunities (which are within our circle of competence) in the market.

We will buy at prices below what we consider to be fair value and sell when they come to our measure of intrinsic value. We may hold at intrinsic value but only if we believe that the company is likely to continue growing at a rate much higher than the cost of capital.

Why does patience pay in value investing? Here is what Benjamin Graham thought on the matter. On 11 March 1995, in his testimony to the Committee on Banking and Commerce of the U.S. Senate (Chaired by Senator William Fulbright of Missouri), the following exchange took place:

“Chair: One other question and I will desist. When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – by advertising, or what happens? What causes a cheap stock to find its value?

Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. [But] we know experience that eventually the market catches up with value.”

I would like to make an observation about companies, particularly multinationals, attempting to buy their shares either through open offers or the current de-listing mechanism. More often than not, companies bully minority shareholders through a combination of deterioration in operating performance and the resultant financials, corporate action like the setting up of 100% subsidiaries through which future business would be routed and threats of future deterioration through transfer pricing in some shape or form. (Multinationals on many occasions bring in the “best” operating practices, but the “worst” corporate governance practices). It reminds an investor of the plight of the patient who when faced with a bill for a large fee from a surgeon stated: “I saw the mask but I didn’t see the gun.” Why do companies resort to behavior that would make the inmates of Tihar Jail look like angels?

There was one company which was there in some of your portfolios which resorted to the crudest form of brazen bullying just before its open offer (although the actions have now been protested by minority shareholders) and another pharmaceutical company which has been using the media to make similar threats – we buy, of course, when we believe the panic is overdone. We detest the tactics of these multinationals “dadas”, but we like the prices they produce. We would rather profit from corporate excellence, than corporate misdemeanors, but in the end we are concerned with irrational pricing. If someone drops his wallet before a gun-wielding highway robber, we will do the picking and the delivery – hopefully at a profit, but only when we are wearing bullet proof vests.

Thanking you,

Warm Regards,

Chetan Parikh